Nothing to fear

In the first of a series of regular columns, the Australian Institute of Company Directors’ chief economist, Stephen Walters, explains why Australia has little to lose from a credit rating downgrade.

Stephen Walters GAICDChief Economist, Australian Institute of Company Directors

01 July 2016

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Image-obsessed politicians will be appalled at the suggestion, but the economic cost of Australia losing its AAA credit rating is probably smaller than they’d expect. In fact, it may even be worth losing the highest credit rating if a downgrade was triggered by the Government borrowing to invest in nation-building infrastructure, but more on that later.

Australia is a privileged member of a small group of countries whose sovereign (government) bond markets attract the coveted AAA rating from the major credit rating agencies, Moodys, S&P and Fitch. This is despite the stark deterioration in our public finances since 2008, thanks to the near-collapse of tax collections and ballooning government spending.

Australia still sits proudly among other top-ranked sovereigns, like Canada, Singapore, Switzerland and a collection of Scandinavian nations. It is elite company. Missing from this list are Japan, the US, the UK and most other European nations. They lost their AAA status in the immediate aftermath of the global financial crisis. The finances of most of these previously top-ranked countries have improved as economic growth has stabilised and tough decisions about budget repair paid dividends. Australia’s comparable debt ratio, by contrast, has been rising rapidly.

Indeed, governments of both political persuasions have failed to return the budget to surplus and rein in debt. This year’s budget pushed out the oft-promised return to surplus to the fiscal never-never of the next decade. In the meantime, a succession of yawning budget deficits means public debt will continue to rise.

Even with this deterioration, our metrics still look better than the lesser-rated sovereigns, thanks to our more favourable starting point. The upshot is that our rating does not look to be in imminent danger, even though rating agencies have sounded warnings about our lack of progress on fiscal repair. Some have hinted at downgrades if more is not done to arrest the decline.

A downgrade would perhaps make it a little harder for us to attract the foreign capital needed to fund our current account deficit. But is the cost of a downgrade really that high? How much higher would interest rates be?

Before thinking about that, it is worth remembering that there is one prominent disadvantage of being AAA rated – it means Australia’s bond market is very attractive to foreign investors. This bias increases the value of the Australian dollar, which damages our trade competitiveness.

History shows that a downgrade would add to the nation’s borrowing costs, and have negative flow-on effects to the ratings of state governments and probably the banks. The credit ratings for the states are benchmarked to the Commonwealth, so AAA-rated New South Wales and Victorian debt, in particular, would be downgraded with the Commonwealth’s.

History shows that a downgrade would add to the nation’s borrowing costs.

Estimates vary about how large the additional impost would be. Some economists predict that the loss of the AAA rating would add only around 20 basis points to Commonwealth government bond yields. That’s a headwind the economy doesn’t need. But bond yields can vary materially over time and the 10-year Commonwealth Government bond yield recently touched its lowest level in nearly 150 years. In this context, an extra 0.2 per cent is not that much. The economy probably can absorb the impact without too much trouble.

The political implications of a downgrade, however, would be profound. There would be reputational damage. No politician wants to be blamed for a ratings downgrade, no matter how modest the impact on the economy.

It could, however, be worth sacrificing our AAA credit rating. With borrowing rates at all-time lows, there is a strong case for borrowing more, not less, to fund long-term, productivity-enhancing infrastructure. More spending on productivity-enhancing infrastructure, for example, could lift Australia’s potential growth rate – our economic speed limit. Faster growth in the economy would mean more jobs and higher standards of living, both of which have important social and economic benefits. These long-term benefits could well be worth the near-term political embarrassment and the extra few basis points on top of government bond rates. That said, once the top rating is lost, it may be harder to win back, an economic reality not lost on the custodians of the nation’s finances.

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